Charles Rotblut: Know When You’re Better Off Playing Roulette

I’m going to put a few numbers behind what I’m assuming several of my fellow experts will be saying: investors too often focus on recent performance when selecting funds. Funds with good recent performance are viewed in a favorable light and funds with lousy recent performance are frowned upon.

S&P Dow Jones Indexes maintains a scorecard of how often top-performing funds remain top-performing funds. According to the latest Persistence Scorecard, which was released just a few weeks ago, only 4.69% of all domestic funds kept their top-quartile rankings for the three consecutive 12-month periods ended March 2013. Put another away, there was a 95% chance the top performing fund you picked three years ago didn’t keep being a top-performing fund. Hardly favorable odds.

Let’s go out even further. Less than half of the large-cap funds tracked by AAII’s annual mutual fund guide had higher 10-year annualized rates of return than the S&P 500. Plus, many of those that did beat the large-cap index only did so by a small margin—a sign investors weren’t adequately compensated for incurring the risk of active management.

Simply put, your odds of correctly determining whether a roulette ball will land on a red or a black number are better than your odds of picking an actively-managed fund that will outperform over the next five or 10 years.

So what is an investor to do? Stop looking at performance first. Rather, figure out what asset classes you need exposure to and then seek out the lowest cost funds that target those assets. Only after doing this should you consider a fund’s long-term performance (at least five years, preferably 10 years). And once you buy a fund, compare its performance to that of its peers; a fund’s performance will primarily be determined by the rules governing what the manager can and cannot invest in.

Charles Rotblut (@charlesrotblut) is a vice president with the American Association of Individual Investors.